Time to brace for further devaluation of the yuan?

WayneArnold

Is China about to launch a new, more dramatic salvo in the global currency war?

Investors are wondering just that after this weekend's leak of minutes from a meeting between top commercial bankers and China's central bank. The leak was more of a gusher -- it found its way onto China's top on-line networks and thence to both Hong Kong's South China Morning Post and the Wall Street Journal -- suggesting to some it was a trial balloon from the People's Bank of China warning markets to brace for further devaluation of the yuan.

Reports of the leaked minutes cast PBoC officials as grappling with a dilemma: with the traditional Lunar New Year celebrations coming up next week, demand for cash to fill gift envelopes threatens to freeze a cooling economy already facing unprecedented capital flight. Bankers want the PBoC to reduce the amount of cash they are required to keep stashed at the PBoC. But the PBoC, according to the reports, is reluctant to do so because it would put further downward pressure on the yuan.

What the PBoC does with the yuan has become a major concern to global markets. Faced with slumping growth, tumbling exports and increasing outflows, the PBoC has pushed the yuan down almost 6% against the U.S. dollar since Aug. 10. While the weaker yuan boosts China's export earnings and thereby helps it fend off slower growth and falling factory prices, it exports deflation to China's trading partners. The yuan's tumble has thus intensified a global slump in commodity prices that has sent crude oil down 15% so far this month and pushed global stocks down nearly 8%.

Weakening the currency of the world's second-largest economy is particularly worrisome to central bankers trying to weaken their own currencies to revive growth, in particular Europe and Japan. Japan's yen has climbed nearly 12% against the yuan since Aug. 10, coinciding with an almost 20% drop in Japanese stocks.

The falling yuan poses such a threat to Japan's economic revival that Japan's central banker, Haruhiko Kuroda, suggested Saturday that China impose capital controls, saying: "capital controls could be useful to manage the exchange rate as regards domestic monetary policy in a consistent and appropriate way."

There's no end of delicious irony in the central banker of Japan suggesting that his counterpart in China block the free flow of capital. But start with the fact that China already has capital controls. Strictly speaking, China's capital account is closed, with citizens limited to moving $50,000 abroad a year and most movements in or out requiring the approval of the State Administration on Foreign Exchange.

Over the years, companies and individuals have devised increasingly innovative ways to circumvent these controls, largely to sneak investment into China. But as China's economy has slowed in recent years, those flows have reversed. The Institute of International Finance estimates that $676 billion leaked out last year.

Naturally, such powerful outflows put downward pressure on China's currency, which helps explain why the PBoC has spent roughly $662 billion to keep the yuan from falling faster than it otherwise might have.

But Kuroda's advice is a reminder that not only does China have capital controls, it still determines the yuan's exchange rate. And it is gradually guiding that rate lower. In December, it said it would start using a basket of trading-partners' currencies -- including not only the dollar, but also the Euro and yen -- to set that value. That means that as other currencies fall, so will the yuan, ensuring what I call "mutually assured depreciation": no one can win the currency war as long as the world's second-largest economy has vowed to depreciate alongside everyone else.

And while the PBoC has blown through $662 billion to defend the yuan, that represents only about 17% of the nearly $4 trillion in reserves it amassed keeping the yuan from rising. It still has $3.3 trillion, the world's largest pile and almost triple the next biggest stash -- Japan's $1.2 trillion.

Suffice to say that if China didn't want the yuan to fall, it has both the capital control knobs and the funds to do so -- if that was what it really wanted. But the PBoC has been under pressure from other areas of officialdom to push the yuan even lower.

And why not? The PBoC has been grappling with what economists call the impossible trinity, which decrees that a central bank cannot maintain a stable exchange rate, an independent monetary policy and allow free cross-border capital flows at the same time.

As China's outflows increase, the PBoC has four options: a) keep blowing reserves defending the currency, b) keep cutting interest rates, including the reserve requirement, to offset the outflows; c) take Kuroda's advice and clamp down on capital flows; or d) give up and let the yuan fall freely until it gets so cheap that flows reverse and its value stabilizes.

Ultimately, only d) - depreciation -- will work. But the PBoC has been trying a combination of all four. Cutting rates and expending reserves only intensified the urge of savers to get money out. That sparked efforts to crack down on currency speculators, notably by limiting currency transactions at foreign banks, leaning on state-owned banks to support yuan offshore, and last week forcing foreign banks to start stashing yuan in reserve like domestic banks.

The leaked minutes may thus be no more than an effort by the PBoC to communicate its frustration and win sympathy for its plight. But sympathy gets the PBoC nowhere. By laying out its dilemma, investors worry, the PBoC may be signaling that its ultimate decision: Faced with the choice between a) supporting global markets by holding back rate cuts to support the yuan, and b) supporting China's economy by cutting rates while letting the yuan slide, the PBoC is likely to do what's best for China.

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